Goal-based investing in fixed income

Bloomberg Professional Services

This article was co-authored by Vikas Jain, Quant Research at Bloomberg and Zarina Nasib, Sustainable Indices Product Manager at Bloomberg.

Traditional fixed income benchmarks typically utilize inclusion/exclusion criteria and market value weighting. Each month, some securities are added or removed, while the majority remain in the index. Market value weighting involves trading each security, including numerous securities that are unchanged, to balance the market value differences between those entering and exiting the benchmark, as illustrated in Figure 1. This approach can be impractical due to operational constraints and transaction costs, as it may involve trading odd lots of many relatively illiquid securities. We propose a Cashflow-managed methodology that leverages the inclusion/exclusion criteria to minimize the need for trading all securities in the benchmark, thereby reducing operational and transaction costs.

The core principle behind Cashflow-managed strategy involves reinvesting cash from coupons and excluded bonds into tradable securities, leaving other positions unchanged. The weight assigned to the new securities is restricted to the total weight available from accrued cash and the securities exiting the portfolio. This approach avoids trading on a large number of securities common to both the current universe and the new universe, thereby minimizing odd lot trades on older, less liquid securities. Investors can further reduce the turnover and transaction costs by holding bonds until maturity. The inclusion and exclusion criteria can be set to achieve the investment objectives for the benchmark, such as targeting a spread, transitioning from one risk factor to another, climate objectives etc.

Methodology

An outline for the Cashflow-managed methodology proposed to construct these indices is given below. On each rebalance date (monthly) –

1. Calculate the market value of securities exiting the index including any cash accrued during the month from coupons, calls, etc.
2. Identify the list of tradable securities for investment, and assess each security to align with the benchmark’s specific objectives
3. Increase the weight of tradable securities by weight equal to the combined market value of the exiting securities and the accrued cash. The weight for rest of the securities remains unchanged. The weight allocation within selected securities is based on their market value

Alternative strategies to minimize turnover include reducing the rebalancing frequency, using optimizations or applying a tolerance limit before exiting securities (buffering). This methodology can be adapted to incorporate these strategies; however, our study concentrates on monthly rebalancing without optimization and buffering. We illustrate the use case and the application of Cashflow-managed methodology using two examples below.

1. Target spread

A corporate bond investor seeking to achieve a specific income above the government yield can leverage this methodology to construct portfolios with low turnover through a straightforward rule-based approach. One simple implementation of this strategy involves rebalancing and investing in securities within a predefined spread range. For example, an investor targeting a 300bps excess return over treasuries could invest in all securities with spreads ranging from 150 to 600 bps. While this strategy can generate approximately 300bps of excess return on a gross basis, its annual turnover rate of 400% would nearly eliminate all the excess return produced.

A bond or portfolio of bonds held until maturity can provide total and excess returns equivalent to the yield and spread at the time of purchase subject to default and callability risks. Therefore, selecting a portfolio with spread equal to the target and holding it until maturity can provide excess return equivalent to target spread. At each rebalance date, the cash generated can be invested in a new sub-portfolio with the same spread target. We backtested multiple strategies targeting different spread levels in the US Investment Grade (IG) and High Yield (HY) markets, rebalancing monthly.

The concept of selling securities where spreads have tightened is similar to a “buy low, sell high” strategy, which has the potential to yield returns exceeding the target spread. This concept can be generalized to selling securities that don’t meet the objective of the portfolio. A summary of the results for this strategy underscores its capability to generate higher excess returns for the higher target spread portfolios, albeit with diminishing returns for very high targets.

The annual turnover for the Cashflow-managed strategy targeting a 3% spread was 59% compared to 400% for the naïve strategy. As the securities entering the portfolio are recent issues, the transaction cost impact on the portfolio reduced significantly to 17 basis points per annum.

2. Carbon emissions reduction

In this example, we consider an investor who holds a diversified corporate bond portfolio and aims to decarbonize it over time. The investor may be averse to significant portfolio fluctuations and may adjust the specific objective definition over time. Most current decarbonization methodologies employ exclusion criteria, which suggest the forced selling of high-emitting issuers. This strategy, however, can avoid such forced sales. The methodology can be customized to gradually exit high emitters at a pre-defined pace, aligning with the investor’s decarbonization targets.

We backtest a monthly rebalancing Cashflow-managed strategy using a Euro corporate benchmark, aiming to reduce carbon emissions.

The implemented solution is intentionally kept simple to demonstrate its potential impact. The Cashflow-managed strategy exhibits a return profile similar to that of the Bloomberg Euro IG benchmark (the “benchmark”) while significantly reducing the portfolio’s carbon emissions relative to the benchmark.

The Cashflow-managed strategy’s turnover was 22% per annum, comparable to that of the benchmark in the same period (20%).  During this period, a significant number of securities were issued, leading to adjustments in the benchmark index.

Conclusion

This simple variation in the benchmark construction methodology can reduce turnover and allow for goal-based investing solutions. The turnover can be further reduced by holding bonds until maturity. In addition to examples discussed in this study, potential applications include:

1. Gradual changes based on risk factors such as ratings, duration, sector or country exposures.
2. Target duration portfolios
3. Portfolios with climate objectives over medium to long run
4. Managing portfolios with intrinsically higher turnover costs, such as emerging market corporates

The Cashflow-managed strategy can be extended for use in an optimization framework in several ways. One approach is to calculate the available weight as defined in the methodology above and apply optimization only to the pre-defined tradable universe, allocating the available weight. The weights of non-tradable securities remain unchanged. Alternatively, investors can configure the optimizer to allow only the purchase of securities within the tradable universe, thereby avoiding additional selling.

The Cashflow-managed strategy may be particularly advantageous for investors aiming to achieve long-term goals or make gradual portfolio adjustments with the reduced need for immediate, large-scale selling. Additionally, as investors’ objectives evolve over time, this methodology allows for an increasingly seamless transition in portfolio positioning, minimizing significant additional turnover.